Corporate Taxation

[An updated version of this article can be found at Corporate Taxation in the 2nd edition.]

[Editor's note: although this article was written in 1992 and there have been changes in the tax law since then, corporate taxation in 2001 is fairly similar to what it was in 1992.]

The corporate income tax is the most poorly understood of all the major methods by which the United States government collects money. Most economists concluded long ago that it is among the least efficient and least defensible of taxes. They have trouble agreeing on—much less measuring with any precision—who actually bears the burden of the corporate income tax, but there is wide agreement that it causes significant distortions in economic behavior. The tax is popular with the man in the street, who believes, incorrectly, that it is paid by corporations. Owners and managers of corporations often assume, just as incorrectly, that it is simply passed along to consumers. This very vagueness about who pays the tax accounts for its continued popularity among politicians.

The federal corporate income tax differs from the individual income tax in two major ways. First, it is a tax not on gross income, but on net income or profits, with permissible deductions for most costs of doing business. Second, it applies only to some businesses—those chartered as corporations—and not to partnerships or sole proprietorships. The federal tax is levied at three different rates on different brackets of income: 15 percent on taxable income under $50,000; 25 percent on income between $50,000 and $75,000; and 34 percent on income above that. The lower-bracket rates are beneficial to small corporations. Of the 3.2 million corporate tax returns filed in one recent year, more than 90 percent were from corporations with assets of less than $1 million. The lower rates, however, had little economic significance. Nearly 94 percent of all corporate tax revenue came from the 8.8 percent of corporations with assets greater than $1 million.

States levy further income taxes on corporations, at rates ranging from 3 percent to 11.5 percent. Because states typically permit deductions for federal taxes paid, net rates range from 1.9 percent to 4.9 percent. Some localities tax corporations as well. A good reason that state and local corporate income taxes remain low is that corporations could easily relocate out of states that imposed unusually high taxes.

How the corporate income tax arose and how it has survived over the decades is a case study of the perniciousness of bad ideas, of why tax systems are often so much worse than they need be, and of how little influence the economics profession has over government policy. Except for emergency taxes in wartime, corporate profits were first taxed in 1909, when Congress enacted a 1 percent tax on corporation income. The rate had risen to 12.5 percent a decade later, and progressive rates were added in 1932. Surtaxes on corporate income were added for "excess profits" and "war profits" during both world wars. The highest peacetime rate, 52.8 percent, was reached in the sixties.

In the forties and early fifties the corporate income tax provided about a third of federal revenues, and as recently as 1966, the proportion was 23 percent. It declined steadily for the next twenty years, reaching a nadir of 6.2 percent in 1983. This was partly by design. The top corporate tax rates fell from 52.8 percent in 1969 to 46 percent in 1979. During much of that time, tax law permitted relatively generous deductions for capital expenditures, either through accelerated depreciation schedules or through such devices as investment tax credits, so that the average tax rate paid by corporations fell even more sharply. Recent research has found that an equally important reason for the relative decline in corporate tax revenue is that U.S. corporations became less profitable. Corporate profits as a percentage of corporate assets, which averaged nearly 11 percent during the sixties, were less than 5 percent from 1981 through 1985.

The Tax Reform Act of 1986 was designed to increase the share of federal revenues collected via the corporate income tax and to decrease the share from the individual income tax. While the top corporate tax rate, like the individual rate, was cut—to 34 percent—deductions for capital expenditures were severely curtailed, and the investment tax credit was repealed. As a result the effective tax rate for many corporations rose. The effort was somewhat successful. Corporate taxes as a share of total federal receipts climbed back to more than 10 percent in 1988 and 1989.

The central problem with the corporate income tax from an economic point of view is that, ultimately, only people can pay taxes. Economists have had great difficulty in assessing the incidence of the corporate tax—that is, on which groups of people the burden falls. As early as the seventeenth century, Sir William Petty, one of the progenitors of modern economics, argued that a tax on the production and sale of commodities would eventually be shifted by producers to consumers, who would pay it in the form of higher prices. Later classical economists disagreed, contending that the tax fell on owners, making it, in effect, a tax on capital. They thought it could not be shifted since, theoretically, a corporation already charging prices that produce maximum profits could not increase prices further without reducing the amount of its goods that people demanded.

Modern research has returned, in part, to Petty's view. A tax on corporate income will cause some firms to leave the business. This reduces the demand for labor, which reduces wages and reduces the supply of goods produced by corporations. With the supply of goods reduced, prices rise. Thus, part of the corporate income tax is paid by shareholders, part by workers through lower wages and fewer jobs, and part by consumers through higher prices.

Other than a general agreement that the corporate income tax has ramifications throughout the economy, economists have made little progress in measuring its incidence with any precision. Even if the basic problem were solved, such an exercise would need to allow for all the special provisions in the corporate tax code in order to measure the effects of the corporate tax in combination with all other taxes, and to assess the effects of international capital movements. Finally, any econometric approach seeking to measure the shifting of the corporate tax burden as a result of tax changes must first isolate the tax effects from the myriad nontax factors affecting business.

From an efficiency standpoint, however, most economists agree that the corporate income tax has two major flaws. First, it penalizes the corporate form of business organization because income is taxed first at the corporate level and then again when paid to stockholders as dividends. A traditional justification for singling out corporations is that they receive special benefits from the state and should pay for them. One problem with this rationale is that if it were true, then all corporations, not just profitable ones, should pay. Another problem is that current corporate tax rates seem disproportionately high for this purpose. But the fundamental problem with this traditional justification is that it harks back to the eighteenth century, when a corporate charter carried with it state-granted privileges such as monopoly power or exemption from specific laws. Today corporations are created by private contract, with the government acting merely as registry and tax collector.

Recent experience shows this disincentive to the corporate form of organization at work. U.S. companies with thirty-five or fewer shareholders can elect what is called Subchapter S status. So-called S corporations have taxable income passed through to the tax returns of the owners, as in a partnership, instead of paying the corporate income tax. In the five weeks surrounding year-end 1986, after enactment of the tax reform bill, which raised the effective rate of corporate taxes, 225,000 companies elected Subchapter S status, compared with 75,000 for all of 1985.

The second major flaw in the corporate income tax is that it misallocates capital by favoring the issuance of debt over equity, because interest payments are tax deductible while dividend payments are not. This favors investments in assets more readily financed by debt, such as buildings and structures (which can be used for many purposes and thus are more easily used as collateral for loans) over investments more logically financed by stock, such as specialized equipment or research and development. In addition, the deductibility of interest payments favors established companies over start-ups, because the former can more easily issue debt securities. Some economists, focusing on this last phenomenon, have argued that this feature makes the corporate income tax a tax on entrepreneurship. During the eighties U.S. corporations issued huge amounts of new debt. Corporate bonds outstanding increased from less than $500 billion outstanding in 1980 to $1.4 trillion in 1988. At the same time, many corporations reduced their outstanding equity by buying back their own shares. The increased emphasis on debt financing in the United States was much more pronounced than elsewhere.

The corporate income tax has survived all efforts to reform, repeal, or replace it, and there is little reason to expect a change in the near future. The simplest fix would be to equalize the treatment of interest and dividends, either by allowing corporations to deduct dividends or by granting an offsetting deduction or credit to stockholders. Most other large industrialized nations use the latter method. A more far-reaching reform, one recommended by economists for decades, would be to completely integrate the corporate and individual income taxes. One way to do this would be to treat corporations as partnerships for tax purposes (that is, treat all corporations like S corporations), imputing all the profits to shareholders and taxing them under the individual income tax. The chief objection to this approach is that stockholders would face a tax liability for profits not distributed as dividends by the corporation. Several integration schemes have been proposed and rejected in the past.

The arguments in favor of leaving the corporate income tax alone are politically compelling. For one thing, the tax has a proven ability to raise revenue, an important consideration for a nation that has run chronic budget deficits. For another, the old aphorism that "an old tax is a good tax" has some validity. Any major change in the tax code changes expectations and imposes new costs and complications during the transition period. But the most compelling rationale for the corporate income tax is the difficulty in assessing its incidence. Since no political constituency sees itself as the primary payer of the tax, none is willing to lobby aggressively for change. Indeed, the art of taxation, as seventeenth-century French administrator Jean-Baptiste Colbert reportedly said, "consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing." Judged by this standard, the corporate income tax has worked well.

About the Author

Rob Norton is a columnist for eCompany Now magazine and was previously the economics editor of Fortune magazine.

The cuneiform inscription in the Liberty Fund logo is the earliest-known written appearance of the word "freedom" (amagi), or "liberty." It is taken from a clay document written about 2300 B.C. in the Sumerian city-state of Lagash.